Chapter 4 : Bond market

instruments

Financial Markets and

Chapter Objectives
Provide Informational Background On
Treasury, Municipal, and Corporate Bonds
Explain The Role Of Bonds To Institutional
Investor
Discuss The Globalization Of Bond
Markets

Financial Markets and

FINANCIAL MARKETS

MONEY MARKETS
Short-term, very liquid,
Low risk debt
T-bills, CDs,
Com papers,
Fed Funds, Repos
(cash equivalent)

Long-term
Fixed-Income
markets
T bonds and Notes,
Municipal bonds,
Corporate bonds,
Mortgage-backed

CAPITAL MARKETS
Long-term, risky
securities
Equity
markets

Derivatives
markets

Common
stock
Preferred
stock

Options,
Futures,
Forwards

Financial Markets and

Fixed Income Investments

Most fixed income instruments specify a
number of features including the following:
The maturity date the date that the
obligation is to be fully repaid, according to
its provisions.
The coupon the income that the investor
will receive each year.
The par value the principal value of the
obligation; usually the original value and also
the amount to be returned to the investor on
the maturity date.
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Fixed Income Instruments

U.S. Treasury Securities

U.S. Government Agency Securities
Municipal Bonds
Corporate Bonds
Other Fixed Income Instruments

Financial Markets and

Background on Bonds
Bonds are often classified according to the
type of issuer
Issuer

Type of Bond

Federal Government
(Treasury)

Treasury Bonds

Federal Agency

Federal Agency
Bonds

State and Local

Governments

Municipal Bonds

Corporations

Corporate Bonds

Financial Markets and

Bond Valuation Process

Bonds are debt obligations with long-term
maturities issued by governments or
corporations to obtain long-term funds
Commonly purchased by financial institutions
that wish to invest funds for long-term periods
The issuer of the bond is obligated to pay
Interest (or coupon) payments periodically
Par value (principal) at maturity
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Issuers of Bonds

(Source: April 2001, Federal Reserve Bulletin)

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Bond Risks and Prices

Higher Risk
Higher Discount
Rates
Lower Bond Prices

Lower Risk
Lower Discount Rates
Higher Bond Prices
Note Inverse
Relationship Between
Risk and Bond Prices

Financial Markets and

Bond Valuation Process

Impact of the Timing of Payments on Bond
Valuation
Bond Price = present value of cash flows

C = Coupon per period (PMT)

Par = Face or maturity value (FV)
i = Discount rate (i)
n = Compounding periods to maturity

C
PV =
(1+ i)1

C + Par
C
+
(1+ i)2
(1+ i)n

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Bond Valuation Process

Consider a bond that has a par value of $1,000, pays
$100 at the end of each year in coupon payments,
and has three years remaining to maturity. Assume
the prevailing annualized yield on other bonds with
similar risk is 12 percent. Calculate the bonds value.
PV = $100/(1+.12)1 + $100/(1+.12)2 + $1100/(1+.12)3
= $951.97

12

PV

PM
T

FV

951.97 100 1000

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Bond Valuation Process

Valuation of Bonds with Semiannual
Payments
Most bonds pay interest semiannually
Double n and halve annual coupon and
discount rate
N
I
PV
PMT FV
6

950.82

50

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1000

12

U.S. Treasury Securities

Bills, notes, or bonds - depending on maturity
Bills mature in less than 1 year
Notes mature in 1 - 10 years
Bonds mature in over 10 years to 30 years
Highly liquid
Very low risk of default, so essentially no credit risk
Issued by the U.S. Treasury to finance federal
government expenditures
Sold in denominations of $1,000
Active OTC Secondary Market
Semiannual Interest Payment
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BOND QUOTES Example:

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U.S. Government Agency

Securities
Sold by government agencies
Federal National Mortgage Association (FNMA
or
Fannie Mae)
Federal Home Loan Bank (FHLB)
Government National Mortgage Association
(GNMA or Ginnie Mae)
Federal Housing Administration (FHA)

Not direct obligations of the Treasury

Still considered default-free and fairly liquid
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Treasury Bonds
Types of Treasury Bonds
Coupon
Stripped Treasury Bonds
Cash flows of bonds are stripped by securities firms
One security represents the principal payment only
Second security represents the interest payments
only

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Inflation-Indexed Bonds
Inflation-indexed bonds deliver coupons and principal
that are indexed on the future inflation rates
They are structured so as to protect and increase an
investor's purchasing power
- They are mainly issued by governments to make it
clear they are willing to maintain a low inflation level
- They are more developed in the UK where they
represent more than 20% of outstanding government
bonds, versus only 7% in the US (1999)
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Inflation-Indexed Bonds
An inflation-indexed bond can be used to
hedge a portfolio against a rise in the inflation
rate
diversify a portfolio based on low correlation with
stocks, fixed-coupon bonds and cash
- Principal value adjusted for the U.S. inflation
rate every 6 months
- Still not very popular in U.S. due to low inflation
rate
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Federal Agency Bonds

Government National Mortgage Association (GNMA)

Issues bonds and uses proceeds to purchase

Federal Housing Administration (FHA)
mortgages
Backed by mortgages and federal government
Loan Bank System (FHLBS)

Federal Home Loan Mortgage Association (Freddie

Mac)
Issues bonds and uses proceeds to purchase
conventional mortgages
Not backed by federal government, but have low credit
risk
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Sources of Revenue and Expenditures

For U.S. State and Local Governments
( For 1998-99 in Millions of Dollars)
General revenues by source:
Property taxes .. 240,107
Sales and gross receipts taxes .. 290,993
Individual income taxes .. 189,309
Corporation net income taxes ..
33,922
Revenue from Federal Government 270,628
Other (other taxes, charges, revues, etc.) 409,505
Total revenues .. 1,434,464
General expenditures by function:
Education . 483,259
Highways .
93,018
Public welfare . 218,957
Other (public safety, environment, interest, etc.) 607,134
Total expenditures 1,402,369
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Sources of Revenue and Expenditures

For State and Local Governments
Cash Inflows:
Taxes (property,
sales, income,
miscellaneous)
User fees
Special
assessments
Intergovernmental
transfers from
federal and state
governments
Borrowings
(net market value
of municipal debt
sold)

Cash Outflows:
Schools and other
educational facilities
Transportation facilities
(highways, airports,
commuter systems, etc.)
States, Cities,
Social services (income
Counties,
and medical support,
School
housing, public safety)
Districts, and
Industrial development
Other Local
incentives
Governments
Administration and
employee payrolls
Interest and debt
repayments
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Motivations for
State and Local Government Borrowing
State and local governments borrow
money
to satisfy short-term cash needs and maintain
adequate levels of working capital,
to finance long-term capital investment like
building schools and highways, and
for advance refunding of higher cost
securities.
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Municipal Bonds
Municipals (i.e., "munis") are debt securities issued by
states, counties, cities, school districts, and other local
units of government.
General obligation bonds (GOs), the least risky of
municipal bonds, are backed by the "full faith and credit"
of the issuing government and are paid back from any
government revenue source.
General obligation bonds usually must be approved by
referendum.
Revenue bonds are paid back from the revenue of the
financed project and do not require a public referendum.
Examples include hospital revenue bonds, industrial
development bonds, and lottery bonds.
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AFTER-TAX INTEREST RATES

The interest on municipal bonds (state and local
bonds) is not taxed at all within their home state.
They are exempt from federal tax, and exempt from
the state tax in their home state.
Interest on Treasury bonds is exempt from state and
local taxes, though not from federal taxes.
The same goes for other bond obligations of the
federal government, such as GNMA (Government
National Mortgage Association) bonds.
Interest on corporate bonds and other private assets
is taxable at Federal and state/local levels
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How Municipal Bonds are Marketed

The selling of municipals is usually carried out
through a syndicate of banks and securities
dealers.
These institutions purchase the securities from
the issuing government units and then resell
them in the open market at a higher price.
Prices paid by the underwriting firms may be
determined by competitive bidding or by
negotiation.
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Municipal Bonds
Exempt from federal income taxes and often state
income taxes
The tax-exempt status makes municipal securities
most attractive to high income investors (i.e., those in
the 31% marginal tax bracket or above).
Tax Reform Act of 1986 placed limitations on taxexempt bond issuance for private purposes
Since 1988 each state is allowed to issue mortgage
revenue and private-purposes tax-exempt bonds only
up to limit of $150 mln
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Municipal Bonds
To see how the tax-exempt status affects
the relationship between yields on munis
and other bonds, consider the after tax
yield.
The after tax yield (ATY) on a Treasury or
corporate bond is:
ATY = Y (1 MTR)
where Y is the before tax yield
MTR is the investors marginal tax rate.
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Municipal Bonds
Consider two bonds, a taxable bond
earning 10% and a tax-exempt municipal
bond earning 8%.
For an investor in the 31% tax bracket, the
after tax yield on the corporate bond is:
ATY = 0.10 (1 0.31) = 0.069 or 6.9%
The investor will prefer the municipal bond
earning a tax free 8%, all else equal.
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Municipal Bonds
The "tax equivalent" yield of a municipal bond
(Y*) is the after tax yield of taxable bond will
be equal to the tax-exempt yield of the munis.
The tax equivalent formula is based on the
after tax yield formula above, solving for Y:
Y = ATY (1 - MTR)
Substitution of Y* for Y and Ym for ATY gives
the tax equivalent formula:
Y* = Ym (1 - MTR)
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Example
For example, if the municipal bond yield
is 5%, to a taxpayer in a 31% tax bracket,
this bond would provide a taxable
equivalent yield of 7.25%:
Y = 0.05 (1 - 0.31)= 0.0725 or 7.25%

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Tax Exempt Equivalent Yields

Tax
Bracket

10% 15%

27%

30%

35% 38.6%

2%

2.22 2.35

2.74

2.86

3.08

3.26

5%

5.56 5.88

6.85

7.14

7.69

8.14

7%

7.78 8.24

9.59

10

10.77

11.4

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Corporate Bonds
When corporations want to borrow for
long-term periods they issue corporate
bonds
Usually pay semiannual interest
Most have maturities between 10-30 years
Recently, Coca-Cola and Walt Disney issued
100-year bonds

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Corporate Bonds
Debt securities issued by corporations.
Vary by:
Level of claim (security)
Credit quality
Term to maturity
Special features

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Corporate Bonds
Characteristics of Corporate Bonds
Indenture
Legal document specifying rights and
obligations of issuer and bondholder
Several hundred pages

Trustee
Represents bondholders, ensures
compliance
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Corporate Bonds: Secured or

Unsecured
Secured bonds feature some sort of collateral to
protect the investor.

Mortgage bonds: backed by land and buildings

Collateral trust bonds: backed by financial assets
Equipment trust certificates: backed by specific pieces
of equipment

Unsecured bonds or debentures are backed only

by the firms promise to pay.
Subordinated debentures: lower priority claim
Income bonds: pay only if profits are earned
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Corporate Bonds: Special

Provisions
The bond contract (the indenture) may include
several important provisions that can influence
the actual maturity of the bond.
Call provision: allows the issuer to buy back or
call in the bond prior to maturity at a specified
call price
Bonds range from freely callable (can be called
any time) to non-callable
Most have deferred calls, which are noncallable for a period of time, then freely callable
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Corporate Bonds: Special

Provisions
Sinking fund provision: requires the issuer
to retire a portion of a bond issue prior to
maturity.
Like a call provision, the investor would typically
receive a specified call price under a sinking
fund provision.

Both call provisions and sinking fund

provisions can shorten the actual maturity of
a bond.
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Corporate Bonds
Characteristics of Corporate Bonds
Sinking Fund Provision
Requirement that the firm retire a certain amount of
the bond issue each year

Protective Covenants
Places restrictions on the firm to protect bondholders
Examples: limits dividends and officer salaries,
restricts additional debt

Call Provisions
Call premium
Advantage to issuers
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Corporate Bonds
Zero coupon bonds: bonds that pay low
or no coupon interest, and instead
provide their return only in the form of
price appreciation.
Sell at a discount from par, mature to par
value

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Other Fixed Income Instruments

Convertible Bonds: Corporate bonds with the
added option to exchange them for a fixed
number of shares of common stock.
Usually lower interest rates than if the same bond
was not convertible

Bonds with Warrants

Allows bondholder to purchase the firms common
stock at a fixed price for a given time period
Usually lower interest rates on bonds with
warrants attached
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Corporate Bonds
Junk Bonds
Junk bonds are also called high-yield bonds
Original-issue junk bonds became popular in
the 1980s
Size of the market: junk bonds represent
about 25 percent of the market value of all
corporate bonds (around $145 billion in 2001)
The risk premium is between 3 and 7 percent
above Treasury bonds
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Corporate Bonds
Corporate Bond Quotations
Priced in eighths
Example: a quote of 101 5/8 for a Disney bond
means $101.62 per $100 par value

Coupon rate
Maturity
Yield To Maturity (YTM)

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Institutional Use of Bond

Markets

Commercial banks and S&Ls

Finance companies
Brokerage firms
Investment banking firms
Insurance companies
Pension funds

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Globalization of Bond Markets

Foreign investment in dollar securities
Foreign issuance by U.S. firms
Increased global investment by pension
and mutual funds
Development of foreign security markets-24 hour trading
Eurobond market
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Globalization of Bond Markets

Eurobond market
In 1960s, U.S. corporations were limited to the
amount of funds they could borrow in the U.S.
for overseas operations.
They began to issue bonds in the Eurobond
market where bonds denominated in various
currencies were placed.
About 75 percent are denominated in U.S. dollars

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International Bond Investing

Eurobond: an international bond that pays cash flows
in a currency not native to the country of issue
Eurodollar bonds are denominated in U.S. dollars,
but sold outside of the U.S.
Yankee bond: a bond denominated in U.S. dollars,
sold in the U.S., but issued by a foreign corporation or
government
Japan
- Samurai bond
Netherlands
- Rembrandt bond
Spain
- Matador bond
UK
- Bulldog bond
USA
- Yankee bond
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Globalization of Bond Markets

Eurobond market
An underwriting syndicate on investment
banks participates in placing the bonds
Issuer can choose the currency in which the bonds
are denominated

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Bond Ratings
Most bonds are rated for default, or credit risk by
one or more rating agency.
Duff and Phelps, Fitch Investors Service, Moodys,
Standard & Poors (S & P)

Ratings from AAA to D, some agencies give

slightly different modifiers or letters
Top four ratings (AAA down to BBB): Investment
Grade Securities
Below the top four ratings: Speculative Grade
Securities (High-yield or junk bonds)
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Bond Ratings

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